24 March 2014
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Schroders
Economic and Strategy Viewpoint
Global growth on track, but downside risks have increased (page 2)
 Recent data suggests that the US economy will rebound in coming months
following firmer readings for employment, retail sales and industrial
production. Growth indicators for the UK, Eurozone and Japan remain firm, but
the emerging markets continue to struggle. Our central view is on track, but
our principal concern this month is that downside tail risks have increased.
 Eurozone deflation is one of our risk scenarios and one where the probability
is increasing judging from the deflation vulnerability indicator (see chart). We
fear that the European Central Bank (ECB) may be repeating the mistakes of
the Bank of Japan in the 1990’s when the economy unexpectedly slipped into
deflation. Downside risks could be compounded by the crisis in the Ukraine
where there is a real threat of higher energy prices. We see the situation
evolving into a prolonged stand-off with damaging effects on European
business and consumer confidence and a drying up of foreign investment
into Russia.
Rising risk of European deflation (page 7)
 Low inflation in the Eurozone is becoming a serious risk that could lead to
outright deflation. We have recreated the IMF’s deflation vulnerability index
which suggests that risk is now ‘high’ for the Eurozone in aggregate (chart).
 While our central view is that Europe will not experience a Japanese-style
episode as recovery continues, we cannot ignore the warning signs that the
risk of deflation is escalating. Deflation or even prolonged very low inflation
could cause many governments’ balance sheets to become unsustainable.
The tail risk is growing, but is the ECB paying attention?
China – Not such a happy New Year (page 13)
 The New Year hasn’t brought much in the way of cheer for China. Activity
data points to an economic slowdown on most fronts which could prove
challenging to a government trying to rebalance. We don’t expect a credit
stimulus but China seems set for accelerated fiscal outlays.
Views at a glance (page 17 )
 A short summary of our macro views and the risks to the world economy.
Chart: Indicator signals heightened risk of Eurozone deflation
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Risk of deflation:
Minimal
Low
Moderate
High
CPI (Y/Y, %)
Source: Thomson Reuters Datastream, Schroders Economic Group, 19 March 2014
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Growth on track, but downside risks have increased
Growth indicators
point to better
growth
Central banks
sound more
hawkish
Signs that the weather is turning bring increased optimism that the world economy
will rebound in the spring. This is certainly the case in the US where readings on
retail sales, employment and industrial production indicate that the economy is
shrugging off the impact of a harsh winter. Our growth indicators for Europe and
Japan also remain positive, however the emerging economies led by China continue
to struggle to gain traction. However, whilst growth is tracking our baseline view, on
the policy front there is a sense that central banks are becoming less supportive.
Although the Federal Reserve continued to taper as expected in March, markets
were surprised at forecasts which indicated tighter than expected policy by end
2015. Concerns were also increased by new Fed chair Janet Yellen's press
conference where she implied rates could be raised in the second quarter of 2015
having said that 6 months could be the lag between the end of tapering (likely to be
October) and the first rate rise. She went on to emphasise that rates were likely to
remain in their current range until the economy was closer to full employment and
inflation significantly higher than today. Nonetheless, the impression is that this was
a hawkish Federal Open Market Committee (FOMC) with the Fed preparing the
markets for a normalisation of policy.
Elsewhere, the Bank of Japan seems content with current policy settings and
relatively relaxed about the economy’s ability to withstand the increase in
consumption tax. In the Eurozone, markets were disappointed with the lack of action
from the European Central Bank (ECB) in the face of sub 1% CPI inflation. Only the
Bank of England appears to be talking of looser policy than markets are currently
expecting by playing down the prospect of rate rises.
Policy error at the
ECB?
Economic recovery would always mean that central banks would have to withdraw
support, however markets seem concerned at the speed with which this is
occurring. Concerns are particularly acute in the Eurozone where there are fears
that the ECB is heading for a major policy error. As our analysis highlights, the risk
of deflation is increasing, bringing comparisons with Japan in the 1990’s.
The Eurozone is recovering and deflationary pressures should ebb and in the near
term low inflation is helping the recovery by boosting real income. However one of
the lessons of Japan’s experience was that policy should focus more on the tail risks
when deflation is a threat. This would suggest that the ECB should be easing more.
Alongside the situation in the Ukraine, which has the potential to derail the upturn
(see below), we would see recent developments as moving the ECB nearer to
quantitative easing.
The Russia- Ukraine crisis: the threat to activity
Developments in
Crimea threaten
activity in both
Russia and
Europe
Tensions between Russia and the West have increased significantly following the
annexation of Crimea from the Ukraine. At the time of writing, the US and EU have
agreed to impose sanctions in the form of travel bans and asset freezes on key
Russian officials. These are modest (to say the least), but the message is that they
will be ramped up should the situation deteriorate. If so then the outcome would be
damaging for both Russia and the West with the former at risk of losing foreign
investment and trade, whilst Europe is primarily exposed through its dependence on
Russian energy supplies.
At this stage, investors in European equities seem unfazed with the DJ Eurostoxx
holding firm, but the ruble (RUB) has weakened substantially, continuing a trend
which has been in place since the beginning of the year (chart 1).
For Europe, the situation in the Ukraine, and the response from the West to
Russia’s actions could have serious economic consequences. Russia is currently
the top crude producing nation in the world and the second largest gas producer. In
2
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the event of trade sanctions that extend to trade in energy, Europe would face a
significant shortage in the supply of oil and natural gas.
Chart 1: European equity markets hold firm whilst the ruble slides
104
102
100
Pro
Russian
forces
enter
Crimea
98
96
94
92
90
88
Jan 14
01/01/2014=100
Feb 14
Euro Stoxx 50
Mar 14
RUB/USD
Source: Thomson Reuters Datastream, Schroders Economic Group. 19 March 2014. Europe is highly
dependent on Russian energy
Russia supplies 29% of total European natural gas needs which amounts to about
7% of the region’s total energy consumption. Unsurprisingly, the Ukraine, Hungary
and Turkey are particularly exposed. However, the most exposed major European
economy is power-house Germany which receives about 40% of its gas from Russia
(see table 1). According to the IEA, Europe receives 36% of its total net crude oil
imports from Russia and about 69% of all gasoil product imports. Neither energy
source would be easily replaced. In the event of a disruption to Russian supplies we
would still expect a significant rise in energy prices in Europe.
Long term this might be addressed through alternative sources such as shale and,
or exports from the US, but in the near term Europe and the rest of the world
economy face the prospect of a stagflationary shock.
On the natural gas side, Norway has spare capacity so could help counter a loss of
Russian supply, for the right price. Storage levels are also fairly plentiful given such
a mild winter. But according to our energy team any major disruption would
definitely see prices adjust higher from current spot levels of around 60p/ therm in
the UK closer to 90p/ therm in order to attract LNG cargoes. In a world of relatively
low US natural gas prices, the competitive impact of even higher energy supply
costs on Europe should not be under-estimated. Efforts by the UK chancellor to
reduce energy costs for UK manufacturers and improve competitiveness in the
recent budget would be blown away by this.
Supply disruption
would push up
gas and oil prices
3
The pressure on crude oil prices would also be significant if there was a disruption
to Russian oil supply. There is virtually no spare capacity in the oil market at present
and inventories are hovering around 10 year-lows outside the US with Saudi
producing at around 96% of peak capacity. Furthermore, we are heading into peak
demand season in the Northern Hemisphere, the so-called driving season, together
with peak air-conditioning season in the Middle East. Europe and the US have
strategic reserves, but any major supply disruption from the Russian side could be
very damaging in terms of higher oil prices.
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Table 1: European exposure to Russian gas
2012
% total energy
consumption
from natural
gas
% of total gas
consumption
from Russian
natural gas
% of total
energy
consumption
from Russian
natural gas
Ukraine
Hungary
Turkey
Czech Republic
Austria
Belgium
Finland
Germany
Poland
Italy
Greece
France
Netherlands
Spain
United Kingdom
35.6
40.0
35.0
17.6
24.6
25.1
10.5
21.7
15.3
38.0
13.1
15.6
36.8
19.5
34.6
60.0
49.1
52.8
80.5
52.2
43.4
102.3
39.9
54.3
19.9
54.0
17.1
5.7
0.0
0.0
21.4
19.7
18.5
14.1
12.8
10.9
10.7
8.7
8.3
7.6
7.1
2.7
2.1
0.0
0.0
European Union*
23.9
29.3
7.0
Source: Schroders 24 March 2014.
*The European Union figure may be overstated as the figure for Russian pipeline exports includes
non-EU countries.
Beyond trade in energy, Russia is not a major trading partner with Europe. Russia
has far more to lose, and actually runs a small trade deficit with Germany.
Financial sanctions could be problematic for some European banking system.
According to BIS figures, European lenders account for nearly three quarters of
global exposure to Russia with France having the highest at $54bn. The second
most exposed European country is Italy at $30bn. In the scheme of things these
figures are not that significant for the European banking system, amounting to
around 0.5% of total assets and so should not pose a systemic threat. However, this
does not take account of potential second round effects from weaker activity, and
the exposure of individual countries, such as Austria which has 1.3% of bank assets
(possibly more) exposed to Russia (chart 2).
4
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Chart 2. Bank exposure to Russia (as at end-September 2013)
$ bn
300
264.2
250
200
193.8
150
100
54.0
35.2
50
0
30.1
Total Europe
Fr
US
It
22.5 18.8 18.8 17.0 17.2 15.8
Ge
Ned
UK
Austria*
Jp
Swe
8.0
Sw
*Data for Austria is from Q2 2012, the most recent available.
Source: BIS, Schroders. 20 March 2014.
From crisis to conflict?
In thinking about how the situation will evolve we would consider three scenarios:
The crisis could
develop into a
prolonged standoff
Uncertainty will hit
investment in
Russia and add a
risk premium to oil
and gas prices
5

The first would be that Russia stops with the Crimea and does not intervene
further in the Ukraine;

The second, would be one of continued unrest in the south and east of
Ukraine such that there are persistent fears that Russia will intervene to
protect the pro-Russian population (i.e. a stand-off);

and third, that those fears are realised in the form of an invasion by Russian
forces and war with Ukraine.
In terms of impact, the first scenario is clearly the most benign as it allows energy
exports from Russia to continue uninterrupted as sanctions are unlikely to be
significantly extended, despite western discomfort over Crimea. There would
probably be scope for the political risk premium on Russian assets to decline,
supporting equities and the RUB.
The second “stand-off” scenario would be more damaging as persistent uncertainty
would hit business and consumer confidence in Europe. Decisions to invest in
Eastern Europe and even core Eurozone countries in close proximity, such as
Germany and Finland, may be put on hold. Energy prices in Europe for gas are
likely to edge higher on fears of supply disruption as discussed above, acting as a
drag on activity – a stagflationary shock. The nascent Eurozone recovery would be
threatened and the ECB are likely to loosen and, or keep policy looser for longer in
such a scenario. Meanwhile, the risk premium on Russian assets would remain, and
possibly increase as western investment in Russia stalls.
The conflict scenario would see a major impact with Russia likely to cut gas and
energy supplies to Europe as a trade war breaks out alongside the fighting. Even if
NATO forces remain on the side-lines, there is likely to be significant disruption to
energy supplies as pipelines through Ukraine are damaged and we enter a new
Cold War. Expect greater damage to household and business confidence, on both
sides, which is likely to send the region into recession. Eastern Europe would be hit
hardest with regards to an economic downturn, given the region’s ties with Russia,
and the close proximity of fighting. The ECB are likely to respond with emergency
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measures, which would include QE.
At this stage, it seems that Europe and Russia have too much to lose to allow the
situation to escalate further and President Putin has said he does not wish to
intervene further in the Ukraine. However, the annexation of Crimea has made him
very popular at home and there will be pressure to go further to “protect” the proRussian population in east and southern Ukraine.
From this perspective the most probable outcome would be the stand-off scenario
whereby Russia continues to threaten Ukraine and sanctions are gradually
escalated. Ironically, business may already be doing the politicians work for them by
withdrawing activity from Russia. There would need to be a major rapprochement to
turn the situation around at this stage and prevent long term damage to the Russian
economy.
Impact on Russia and the wider emerging markets
Russia may have
seen some 2.5% of
GDP leave the
economy in Q1
Looking more specifically at Russia, questions have been raised over her debt, and
the possibility of a repeat of the 1998 crisis. For example, Standard & Poor’s have
revised their outlook to negative. At 12% of GDP, total external debt issuance is
similar to the levels seen in 1998, though the vulnerability now lies more in the
private than public sector. Meanwhile, slowing growth – our forecast was 1.8% for
this year, before recent events unfolded – and a weaker currency will increase debt
service costs. However, if we look at short term financing requirements, using our
preferred gross external financing requirement (GEFR) metric (short term debt –
current account), it stands at a mere 0.4% of GDP and 1.5% of reserves, which is
far more manageable. The fall in the currency will also have boosted RUB revenues
from energy sales, helping Kremlin finances.
Concerns will be justified if Russia faces a prolonged political and economic
isolation. The full extent of capital flight will not be revealed until the first quarter’s
balance of payments data comes out in April, but an attempt at estimating the net
outflows to date can be made by looking at central bank intervention in the foreign
exchange markets and its current account position. Capital Economics estimates
that, to date, $50bn, or 2.5% of GDP, has left Russia this year, and project that the
first quarter will see $70bn of outflows in total. With foreign reserves of $444.1bn
currently, the central bank seems in a resilient position for now. However, credit
conditions will be tightening in the Russian economy and hurting already anaemic
growth.
Within emerging markets, India and China could be quite exposed on the energy
front. Commodity markets should, broadly speaking, see price increases. Ukraine’s
role as a wheat exporter will push up agricultural prices, while uncertainty over oil
and gas supply will push up the energy matrix. This could all be supportive in the
short-term for some commodity exporters, particularly if they are energyindependent. However, we should not neglect the role of politics. It seems unlikely
that China would join Western sanctions on Russia, and the end result could be that
sanctions result in cheaper energy prices for Asia, as Russia pumps gas and oil
previously destined for Europe towards less hostile nations at a significant discount.
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Rising risk of European deflation
Recession,
pressure to
deleverage , and a
need to boost
competitiveness
through lower
wages have
contributed to
growing deflation
risks
Whilst much progress has been made since the financial crisis of 2008/09, the
threat of deflation continues to linger. In Europe, where a secondary sovereign debt
crisis followed, the adjustment in household and government balance sheets has
been a significant headwind on activity. Emergency austerity and unprecedented
action from the European Central Bank (ECB) helped to stop and reverse the selffulfilling spiral of banks infecting sovereigns, and vice-versa. More recently, the
banking sector has also been repairing its balance sheet by selling assets, but also
reducing the supply of new credit, and in turn, contributing to the fall in business
investment and demand in the real economy.
The impact of serial sectoral deleveraging is slowly being realised in the inflation
data. This puts policy makers at a quandary. The ECB’s president Mario Draghi has
in recent press conferences argued that lower price inflation is helping households
to cope with the deleveraging process. However, he simultaneously acknowledges
that if inflation remains too low for too long, then there is a risk of sleep walking into
outright deflation.
For the purpose of this note, we define deflation as a widespread and persistent fall
in consumer prices. The most recent and probably best example of deflation is
Japan’s experience through the best part of the last two decades. This is the
outcome that central bankers worldwide desperately acted to avoid in 2008/09 – a
period which changed the playbook for central banks with the introduction of
quantitative easing.
The burden of balance sheet adjustment for the household and government sectors
has caused aggregate demand to fall, causing corporates to hold back when
considering passing on cost increases. Indeed, in Greece and Cyprus, prices are
falling outright.
Eurozone inflation
surprises have
been a big
negative shock,
forcing
economists to
lower their
forecasts
European inflation has been surprising to the downside for the past few months. In
fact, the magnitude of the downside surprises has reached record levels in the past
couple of months (see chart 3). Those downside surprises have prompted most
economists to revise down their forecasts. However, those downward revisions
have accelerated in recent months, and the latest consensus amongst economists
is that Eurozone inflation will average less than 1% in 2014 (see chart 4). Given that
we are still in the first quarter, this does not bode well.
Chart 3: Citi Eurozone inflation
surprise index
Chart 4: Consensus Economics’
Eurozone inflation forecast (median)
Index
80
%
2.0
60
1.8
40
1.6
20
1.4
0
-20
1.2
-40
1.0
-60
0.8
Jan 12
-80
99
01
03
05
07
09
11
13
Jul 12
Jan 13
Jul 13
2013
2014
Jan 14
Source: Thomson Datastream, Citigroup, Consensus Economics, Schroders. 15 March 2014.
7
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In a speech at the National Press Club in Washington, IMF President Madame
Lagarde echoed Draghi’s concerns on the risks of persistently low inflation: “With
inflation running below many central banks’ targets, we see rising risks of deflation,
which could prove disastrous for the recovery…If inflation is the genie, then deflation
is the ogre that must be fought decisively”; clearly trying to prod the ECB to take
more drastic measures.
Low inflation is
also becoming
widespread within
goods and
services, and
more so than in
the UK or US
Not only is annual headline HICP inflation very low at 0.7%, the breadth or
widespread nature of low price rises is a concern. Jefferies International has kindly
provided us with their analysis of the extent of the problem in the Eurozone
compared to the UK and US. In the Eurozone, a mere 15% of the core inflation
basket is running with an annual inflation rate of over 2%, compared to 54% in the
UK and 37% in the US (see chart 5).
Chart 5: Low inflation is becoming widespread amongst goods and services
Share of core indices with above 2% inflation
90
80
70
60
50
40
30
20
10
0
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
UK
Euro area
US
Source: Jefferies’ European Economics Team. 17 March 2014.
Deflation vulnerability indicator
The IMF’s
deflation
vulnerability index
can help in
assessing the
degree of deflation
risk that exists in
Europe
1
2
In order to better assess the risk of future outright deflation in the Eurozone, we
have reconstructed and updated a piece of analysis from the IMF which attempts to
measure and flag the risk of deflation with a two-year outlook. The deflation
vulnerability indicator, which was first introduced in Kumer et al (2003)1, and later
updated by Decressin & Laxton (2009)2, is a simple indicator that summarises
whether a critical number of macro variables have reached a level which would
signal a rise in deflation vulnerability. These indicators include inflation itself,
measures of spare capacity, equity market performance, growth in lending and the
behaviour of the real effective exchange rate. The information is amalgamated into a
simple score, which then describes the level of risk of deflation in the future. For
more inflation on the precise inputs, please see box 1.
Deflation: Determinants, Risks and Policy Options, Kumer et al, IMF Occasional Paper, 30 June 2003.
Gauging Risks for Deflation, J. Decressin & D. Laxton, IMF Staff Position Note, 28 January 2009.
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Box 1: Deflation vulnerability indicator methodology
The indicator is based on 11 questions (see below) created from a range of
macroeconomic variables. Each question must be answered with a yes or no and
given a corresponding score of 1 or 0 respectively. The scores for each country are
then aggregated (on an equal weighted basis) and assigned a risk category. An
index value below 0.2 is considered to point to a minimal risk of deflation, between
0.2 and 0.3 is low, between 0.3 and 0.5 is moderate and any value above 0.5 is high
risk (see table 1).
The higher the indicator, the more likely it is that an economy will suffer a prolonged
period of falling prices. A high index value also signals a potentially harmful
interaction of variables, for example, price declines with a binding zero interest floor.
When the original paper was written by Kumar et al in 2003, the proportion of high
risk country observations that experienced lower price levels two years after
entering the risk category was found to be 25.4%, and just 1% for low risk countries
(table 1).
Table 1: Risk Category and Historical Price Observations
Proportion of country observations
Vulnerability that experienced lower price levels
2yrs after entering the risk category
Minimal
Low
Moderate
High
t
<= 0.2
0.2 < x <= 0.3
0.3 < x <= 0.5
> 0.5
t + 8 quarters
1.0%
2.2%
14.2%
25.4%
Source: IMF (2009), taken from Kumar et al (2003).
The questions are as follows:
 Is CPI inflation < 0.5?
 Is GDP inflation < 0.5?
 Is core CPI inflation < 0.5?
 Output gap widened more than -2 per cent in past four quarters?
 Is the latest output gap lower than -2 per cent?
 Is growth in last three years < 2/3 growth in previous ten years?
 Has the equity index declined by more than 30 per cent in the past three years?
 Has the real exchange rate appreciated more than 4 per cent over the past year?
 Is Q4/Q4 credit growth < Q4/Q4 nominal GDP growth?
 Has cumulative credit growth been less than 10 per cent over the past three
years?
 Is broad money growing slower than base money by > 2 percent for last 2 years?
The indicator
worked well in
predicting Japan’s
extended deflation
episode
9
Before looking at the latest situation in Europe, it is worth examining the signal the
deflation vulnerability indicator provided in the run-up to and during Japan’s
extended deflation era. The indicator first started to highlight moderate and high risk
of deflation in 1993, well before the first dip into negative territory for the CPI index
(see chart 6). It continued to flag moderate to high risk right up until 2006/07, when
Japan was finally emerging from deflation. Note that the indicator only briefly
reduced the risk category to low in 2007/08, before returning to moderate and then
high risk again by the middle of 2008. The spike up in inflation just before that in
2008 was largely driven by higher commodity prices – the core inflation rate
remained very weak, and only temporarily ventured into positive territory.
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Chart 6: Deflation vulnerability indicator for Japan (1990-present)
4
3
2
1
0
-1
-2
-3
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Minimal
Low
Moderate
High
CPI inflation (% Y/Y)
Core inflation (% Y/Y)
Source: IMF, Thomson Datastream, Schroders. Data up to 2013Q4. 19 March 2014.
The Eurozone is
currently at high
risk of deflation
based on the IMF’s
indicator
It seems that in the case of Japan, the indicator did a reasonable job of warning of
the escalating risk of deflation, and continued to signal moderate and high risk for a
considerable period afterwards. It was certainly better than the forecasts by the
Bank of Japan which did not see deflation coming in the 1990’s. In Europe’s case,
many countries are in the high risk category – including the Eurozone aggregate –
but some remain in the moderate risk category (see chart 7).
Chart 7: Deflation vulnerability indicator points to high risk of Eurozone deflation
1.0
0.9
0.8
0.7
0.6
1.0
0.9
High
0.90
Moderate
0.73
0.7
Low
0.70
0.64
0.64
0.5
0.6
Minimal
0.5
0.55
0.4
0.8
0.45
0.4
0.45
0.36
0.3
0.36
0.3
0.2
0.2
0.1
0.1
0.0
Cyp
Ire
Gre
Spa
CPI: -2.6% 0.1% -0.9% 0.1%
Por
-0.1%
EZ
0.7%
Fra
Neth
Ger
Ita
1.1%
1.1%
1.0%
0.4%
0.0
Source: IMF, Thomson Datastream, Schroders. Data up to 2013Q4. 19 March 2014.
Peripheral Europe
is at greater risk
than core
10
It is worth noting that the IMF estimates that there is roughly a one in four chance of
a country/region experiencing falling prices in 2 years from the point of reaching the
high risk category. Moreover the Eurozone has only just crossed that threshold,
having had low to moderate risk in recent quarters (see chart front page).
On a country by country basis, we can see the different conditions the large member
states have before and after the financial crisis (see chart 8). For example, between
2003 and 2006/07, Germany’s indicator warned of low to moderate risk of deflation,
while France, Spain and Italy largely saw minimal risk. This reflects the internal
devaluation Germany endured in order to boost its competitiveness, having entered
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the Euro at a widely perceived uncompetitive level compared to its new partner
member states. During the financial crisis, most member states saw their deflation
risk indicators rise to high risk. Since then, some of the stronger economies that had
less need to adjust their public and private balance sheets, or their wages to
improve their competitiveness, saw their indicators fall back to minimal and low risk.
However, most of peripheral Europe has remained in the high risk category since
2008, with Spain and Italy serving as good examples.
Chart 8: Headline HICP annual inflation vs. deflation vulnerability indicators
Germany
3.5
France
4.0
3.0
3.0
2.5
2.0
2.0
1.5
1.0
1.0
0.5
0.0
0.0
-0.5
-1.0
-1.0
03 04 05 06 07 08 09 10 11 12 13
Minimal
Low
Moderate
High
03 04 05 06 07 08 09 10 11 12 13
Minimal
Low
Moderate
High
Italy
4.5
Spain
6.0
4.0
5.0
3.5
4.0
3.0
3.0
2.5
2.0
2.0
1.0
1.5
1.0
0.0
0.5
-1.0
0.0
03 04 05 06 07 08 09 10 11 12 13
Minimal
Low
Moderate
High
-2.0
03 04 05 06 07 08 09 10 11 12 13
Minimal
Low
Moderate
High
Source: IMF, Thomson Datastream, Schroders. Data up to 2013Q4. 19 March 2014.
Our central view is
that the Eurozone
will avoid Japanese
style deflation...
11
Is deflation coming?
As discussed in last month’s Economic and Strategy Viewpoint, our central view is
that Japanese style deflation will not take hold in Europe. So far, households in most
Eurozone member states have continued to have well anchored inflation
expectations, and they have not started to exhibit a change in behaviour which
would worry us. The household savings rate in not only the Eurozone aggregate, but
also in almost every member state with low inflation, has fallen along with
consumption and real disposable income. This tells us that households are not
postponing consumption on the back of expectations that prices will fall in the future
– as was the case in Japan. Moreover, a number of peripheral member states, most
notably Ireland, Greece and Spain have significantly improved their competitiveness
levels and are making progress on recapitalising their banking systems. More
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clearly needs to be done, but Japan lagged in these areas making it more difficult to
restore growth.
However, we
cannot ignore
growing risks, and
the implications for
the sustainability of
government
balance sheets.
While we are confident that the Eurozone is different from Japan in the 1990’s, there
are however some stark similarities. The appreciation of the real exchange rate and
rise in the current account surplus is emulating the Japanese experience, the impact
of which on prices was arguably underestimated. Draghi has been more vocal on
the strength of the euro of late, but has so far refrained from directly saying that it is
becoming a concern.
The implications of deflation, or indeed even very low inflation for a prolonged period
of time has a profound impact on the debt dynamics for those countries going
through the experience. With lower inflation comes lower nominal GDP growth,
which could make their public finances unsustainable. Deflation increases real
interest rates thus squeezing the economy further and worsening debt dynamics.
In conclusion, deflation in the Eurozone is not our central view as we see economic
recovery continuing, however, we feel that the risk is rising, which is why we
introduced a Eurozone deflation scenario last month. The analysis based on the
IMF’s deflation vulnerability indicator is impossible to ignore and we believe
supports our view. The warning signs are clear, but is the European Central Bank
paying attention?
12
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China: Not such a happy New Year
Slowdown and stimulus
Almost all data
points to a Chinese
slowdown
It is hard to find much to be cheerful about in the data in China. Recent figures for
the January/February period (combined due to the Chinese New Year distortion)
point to weakness across the economy.
We had already had some indication of manufacturing trouble with the HSBC PMI at
49.5 in January (a reading above 50 denotes expansion), and it fell further in
February to 48.5. This forward looking indicator was corroborated by industrial
production and investment numbers which fell short of expectations. Manufacturing
growth was particularly weak, slowing from 17.5% year on year in December to
15.1%. You could be optimistic and argue that this is the much needed rebalancing
in action, except that retail sales also struggled, at 11.8% year on year compared to
13.6% growth in December. This weakness seems to be driven by slower growth in
property related consumption; furniture, appliances and so on, emphasising the role
of property in the Chinese growth story. Unfortunately, property was among the
casualties in the data, starts and sales both contracted, and price growth continued
to stall, with more cities reporting price falls than in the second half of last year
(chart 9 below).
Chart 9: Foundations crumbling in the housing market?
Number of cities reporting monthly house price
increases/decreases (new build)
1.6%
70
60
Housing is slowing
at the margin
1.2%
50
40
0.8%
30
0.4%
20
0.0%
10
0
Mar13 May13 Jul13 Sep13 Nov13 Jan14
Decline (m/m)
Increase (m/m)
-0.4%
Jan 11
Oct 11 Jul 12 Apr 13 Jan 14
National House Prices (m/m)
Source: Thomson Datastream, Schroders. 19 March 2014
Don’t count on a
credit stimulus
Shadow financing
is still slowing
13
The slowdown has prompted many to ask whether government stimulus might be
around the corner. The National People’s Congress (the national legislature) met
and announced a series of targets earlier this month, setting the growth target once
again at 7.5%. This would certainly seem to suggest stimulus will be needed.
However, Premier Li Keqiang has said there is flexibility around the target, and
Finance Minister Lou Jiwei has reportedly said growth of 7.2% would be sufficient.
Both said that jobs are more important than growth, so watch employment for
indications of stimulus; the labour market is currently quite tight. However, Premier
Li has said China will speed up investment and construction to ensure stable
expansion of demand – we will have to wait and see how (and if) this is achieved.
We had expected the tighter monetary conditions seen late last year and running
into 2014 to have a negative impact on growth, reflected in our bearish growth
forecast. Provided credit continues to tighten we would expect more of the same,
and certainly all the noises from the authorities support this. Total social financing
(TSF) data so far this year might make it look as though a new credit boom is
occurring, particularly given the high level seen in January (chart), but the growth
rate continues to slow, and in February TSF actually fell in year on year terms. We
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expect a continued squeeze on credit, particularly shadow financing, and by
extension continued problems for investment.
Chart 10: Total social financing growth is slowing
RMB tn (3m moving average)
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Bank loans
Non-bank lending
TSF
Source: Thomson Datastream, Schroders. 19 March 2014
Currency volatility
reflects PBoC
intervention
Of course, monetary conditions at the moment look less tight; the interbank rate has
dropped sharply having climbed throughout the second half of last year. However,
this reflects FX intervention by the People’s Bank of China (PBoC) to weaken the
currency (chart 11), and should not be read as a sign of monetary easing aimed at
propping up growth. This intervention was aimed instead at introducing more twoway volatility into the yuan-dollar (CNYUSD) exchange rate. Since 2005, the yuan
has appreciated about 35% against the dollar, steadily appreciating or stable for the
entire period. Given the interest differential between the yuan and the dollar, this led
to considerable funds flowing into the currency to exploit the carry trade. In turn, this
provided a massive source of liquidity to the Chinese economy that was not under
central bank control. Though the PBoC has not said it is deliberately engineering the
recent weakness, there have been reports of large scale dollar purchases by the
PBoC, and it seems likely it is trying to squeeze out these carry trade investors and
so regain control over credit provision.
How does this relate to the lower interbank rates? In order to buy dollars the PBoC
must sell yuan, essentially injecting large amounts of CNY liquidity onto the market
in the process. We consequently expect rates to begin rising again once the PBoC
is comfortable that the carry trade has been sufficiently suppressed. Equally, the
currency should continue to appreciate this year, but at a more moderate pace and
with greater volatility than in the past.
14
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Chart 11: Interbank rate and the yuan exchange rate
%
6.0
6.0
5.0
6.1
4.0
6.1
3.0
6.2
2.0
6.2
1.0
0.0
Aug 13
6.3
Sep 13
Oct 13
Nov 13
Interbank rate
Dec 13
Jan 14
Feb 14
CNYUSD (rhs,inverted)
Mar 14
Source: Thomson Datastream, Schroders. 19 March 2014
Scuffles in the shadows
This is not the only problem the monetary authorities are attempting to manage. A
number of trust products have defaulted (and been bailed out) this year, and more
recently we saw China’s first domestic bond default, and now market focus is on a
Chinese real estate developer unable to repay its $565mn in debt (mainly bank
loans). All of this has given fresh impetus to concerns that a Chinese financial crisis
is imminent.
Fears of a financial
crisis are building
but overdone
Broker estimates put the shadow banking sector at around 63% of GDP at the end
of 2013, and RMB 3-5tn of trust products are thought to be up for redemption this
year, along with RMB2tn of corporate bonds. These numbers are large historically,
as well as in absolute terms, and further defaults seem likely. Close to 30% of trust
products invest in mining and other “basic industry” sectors, and another 9% in
property. Given the overcapacity issues in China and the weaker data seen in the
housing market (discussed above), again, more defaults seem likely.
The question, then, is whether these defaults will be enough to spark a financial
crisis. So far, trust product defaults have been bailed out to some extent (the
government has recently been imposing some losses on investors), and the
corporate bond default was small and flagged in advance – the issuer having been
downgraded to CCC last year. But if a trust product were allowed to default
completely, could we see a crisis? Trust companies themselves are unable to create
money, and have little to no securitisation and low leverage. A trust company failing,
therefore, has limited direct impact on the financial system. The main concern is its
impact on confidence, a full default could lead to a panicked rush out of the shadow
financing system and a credit crunch.
Government has
the capacity to
prevent a crisis, for
now
15
This, though, presupposes that defaults go unchecked. It seems extremely unlikely
to us that the authorities will permit a large scale default in the near future. Though
the imposition of minor losses in recent trust default cases shows a willingness to
move in this direction, we expect a very gradual approach will be adopted to
accustom Chinese investors to the concept of moral hazard. There is also a
reputational risk; 84% of trust companies are backed by governments and large
financial institutions. Default by such a trust risks nurturing the idea that the
government or bank associated with the product is also bankrupt, a loss of
confidence of that kind would be devastating. We think it is more likely that the
government will continue to bail out trust products, imposing some losses on
investors (so returning the principal but not interest payments) and potentially letting
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smaller products, particularly those offered by independent trust companies, default
completely. It is important that moral hazard be managed and reduced but there is
no desire to precipitate a crisis. Of course, this could be storing up more pain for the
long run, but the authorities seem willing to take that chance for now.
Reform update: urbanisation
In the middle of March, China revealed a plan to push for urbanization which
included a new wave of infrastructure spending. The total funds to be invested have
not been revealed, but the cost of redeveloping rundown shantytowns has been
estimated at RMB1tn this year alone.
Urbanisation plan
will support but not
accelerate growth
3
The plan targets an increase in the hukou3 urbanization ratio from 35.3% currently to
45% by 2020 – which equates to an extra 160 million people. While this is a faster
rate of growth than under the previous plan, at 0.9 percentage points (ppts) per year
it is still below the 1.3 ppts rate seen in the past decade. So this is not going to see
an acceleration of trend growth. Still, the investment involved, in infrastructure and
property, will provide support to growth, and the increased provision of urban hukou
with all it entails (higher pension coverage and other social welfare spending) will
help boost consumption and rebalance the economy.
The hukou is a registration system used to identify a person as a resident of an area. Without an urban hukou, people are
unable to claim urban services like healthcare and other welfare benefits.
16
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Schroder Economics Group: Views at a glance
Macro summary – March 2014
Key points
Baseline

World economy on track for modest recovery as monetary stimulus feeds through and fiscal
headwinds fade in 2014. Inflation to remain well contained.
Recent upswing driven by lower inflation supporting real incomes and consumption, the manufacturing
inventory cycle and, in the US and UK, reviving housing markets.
US economy faces reduced fiscal headwind and is gradually normalising as banks return to health and
private sector de-leverages. Fed to complete tapering of asset purchases by October 2014, possibly
earlier, with the first rate rise expected in the third quarter of 2015.
UK recovery risks skewed to upside as government stimulates housing demand, but significant
economic slack should limit any tightening of monetary policy. No rate rises 2014 or 2015.
Eurozone recovery becomes more established as fiscal austerity and credit conditions ease in 2014.
Low inflation likely to prompt ECB to cut rates in coming months, otherwise on hold from then on
through 2015. More long-term refinancing operation (LTRO’s) likely in 2014.
"Abenomics" achieving good results so far, but Japan faces significant challenges to eliminate
deflation and repair its fiscal position. Bank of Japan to step up asset purchases to offset consumption
tax hikes in 2014 and 2015. Risk of significantly weaker JPY.
US leading Japan and Europe. De-synchronised cycle implies divergence in monetary policy with the
Fed eventually tightening ahead of others and a stronger USD.
Tighter monetary policy weighs on emerging economies. Region to benefit from current cyclical
upswing, but China growth downshifting as past tailwinds (strong external demand, weak USD and
falling global rates) go into reverse, and the authorities seek to deleverage the economy. Deflationary
for world economy, especially commodity producers (e.g. Latin America).







Risks

Risks are still skewed towards deflation, but are more balanced than in the past. Principal downside
risk is a China financial crisis triggered by defaults in the shadow banking system. Upside risk is a
return to animal spirits and a G7 boom.
Chart: World GDP forecast
Contributions to World GDP growth (%, y/y)
6
4.9 5.0
4.8
4.8
4.4
5
Forecast
4.1
3.6
4
3
2.4
3.1
2.8
2.6
3.0
3.1
14
15
2.0
2.2
2
1
0
-1
-0.9
-2
-3
00
01
US
BRICS
02
03
04
05
06
07
Europe
Rest of emerging
08
09
Japan
World
10
11
12
13
Rest of advanced
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from November 2013. Please note
the forecast warning at the back of the document.
17
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Schroders Baseline Forecast
Real GDP
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
Prev.
(3.0)
(2.1)
(3.0)
(1.1)
(2.1)
(2.4)
(1.3)
(4.7)
(5.5)
(7.3)
Consensus 2015
2.9
3.1
2.0
2.2
2.8
3.0
1.1
1.4
1.8
2.2
2.7
2.1
1.4
1.3
4.5
4.7
5.4
5.6
7.4
7.3
Prev.
(2.7)
(1.5)
(1.5)
(1.0)
(1.5)
(2.9)
(1.9)
(4.8)
(4.0)
(2.6)
Consensus 2015
3.0
2.8
1.6
1.5
1.7
1.4
0.9
1.2
1.5
1.7
2.0
2.7
2.6
1.5
5.6
5.1
4.6
4.1
2.9
2.9
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2013
2.6
1.3
1.9
-0.4
0.5
1.9
1.6
4.9
5.5
7.7
2014
3.0
2.1
3.0
1.1
1.9
2.6
1.4
4.5
5.3
7.1
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2013
2.7
1.4
1.5
1.4
1.6
2.6
0.1
5.2
4.7
2.6
2014
2.8
1.4
1.5
0.8
1.3
2.3
1.9
5.3
4.3
2.7
Current
0.25
0.50
0.25
0.10
6.00
2013
0.25
0.50
0.25
0.10
6.00
2014
0.25
0.50
0.10
0.10
6.00
Prev.
(0.25)
(0.50)
(0.25)

(0.10)
(6.00)
Current
2864
325
NO
20.00
2013
4033
375
YES
20.00
2014
4443
375
YES
20.00
Prev.
(375)
YES
20.00
Current
1.65
1.38
102.4
0.83
6.23
2013
1.61
1.34
100.0
0.83
6.10
Prev.
2014
1.63  (1.58)
1.34  (1.32)
(110)
110.0
0.82  (0.84)
(6.00)
6.00
Y/Y(%)
1.2
0.0
10.0
-1.2
-1.6
106.1
109.0
107.6  (104)
-1.3













Prev.
(3.1)
(2.1)
(3.0)
(1.4)
(2.3)
(1.9)
(0.9)
(4.9)
(5.9)
(7.5)
Consensus
3.2
2.3
3.1
1.4
2.0
2.5
1.3
4.8
5.5
7.3
Prev.
(2.8)
(1.6)
(1.5)
(1.5)
(1.9)
(3.0)
(1.4)
(4.9)
(4.1)
(3.0)
Consensus
3.0
1.8
2.0
1.3
1.9
2.2
1.7
5.2
4.4
3.2
Inflation CPI
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
















Interest rates
% (Month of Dec)
US
UK
Eurozone
Japan
China
Market
0.35
0.77
0.34
0.19
-
2015
0.50
0.50
0.10
0.10
6.00
Prev.
(0.50)
(0.50)
(0.25)

(0.10)
(6.00)
2015
4443
375
YES
20.00
Prev.
(375)
YES
20.00
Market
1.16
1.63
0.53
0.19
-
Other monetary policy
(Over year or by Dec)
US QE ($Bn)
UK QE (£Bn)
Eurozone LTRO
China RRR (%)
Key variables
FX
USD/GBP
USD/EUR
JPY/USD
GBP/EUR
RMB/USD
Commodities
Brent Crude
Prev.
2015
1.55  (1.50)
1.27  (1.25)
(120)
120.0
0.82  (0.83)
(5.95)
5.95
102.7 
(99)
Y/Y(%)
1.2
0.0
10.0
-1.2
-1.6
-1.3
Source: Schroders, Thomson Datastream, Consensus Economics, 20 March 2014
Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.
Market data as at 20/03/2014
Previous forecast refers to November 2013
* Advanced m arkets: Australia, Canada, Denmark, Euro area, Israel, Japan, New Zealand, Singapore, Sw eden, Sw itzerland,
Sw eden, Sw itzerland, United Kingdom, United States.
** Em erging m arkets: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela, China, India, Indonesia, Malaysia, Philippines,
South Korea, Taiw an, Thailand, South Africa, Russia, Czech Rep., Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria,
Croatia, Latvia, Lithuania.
18
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I. Updated forecast charts - Consensus Economics
For the EM, EM Asia and Pacific ex Japan, growth and inflation forecasts are GDP weighted and
calculated using Consensus Economics forecasts of individual countries.
Chart A: GDP consensus forecasts
2014
2015
%
%
8
8
7
7
EM Asia
6
EM Asia
6
EM
5
EM
5
4
4
Pac ex JP
Pac ex JP
3
3
US
2
Japan
UK
1
Eurozone
0
US
2
UK
Eurozone
1
Japan
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
Jan
Feb
Month of forecast
Month of forecast
Chart B: Inflation consensus forecasts
2014
Mar
2015
%
%
6
6
EM
EM
5
5
EM Asia
4
Pac ex JP
3
EM Asia
4
3
Pac ex JP
Japan
UK
UK
US
2
2
Japan
Eurozone
US
1
Eurozone
1
0
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
Month of forecast
Jan
Feb
Mar
Month of forecast
Source: Consensus Economics (March 2014), Schroders
Pacific ex. Japan: Australia, Hong Kong, New Zealand, Singapore
Emerging Asia: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand
Emerging markets: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, Argentina, Brazil,
Colombia, Chile, Mexico, Peru, Venezuela, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, Turkey,
Ukraine, Bulgaria, Croatia, Estonia, Latvia, Lithuania
The views and opinions contained herein are those of Schroder Investments Management's Economics team, and may not
necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document
does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this
document. The information and opinions contained in this document have been obtained from sources we consider to be
reliable. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability
that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or
any other regulatory system. Reliance should not be placed on the views and information in the document when taking
individual investment and/or strategic decisions. For your security, communications may be taped or monitored.
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